"Hard Brexit" hint sinks sterling, raises relocation risk

Following Prime Minister Theresa May’s suggestion that the UK is heading for a “hard” Brexit, international companies are now more likely to relocate than risk remaining in the country.

04/10/2016

Azad Zangana

Senior European Economist and Strategist

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After months of speculation as to the timing and direction of the UK’s Brexit negotiations, Prime Minister May not only revealed that she plans to trigger Article 50 by March 2017 (thereby starting the negotiation process), but also that she is prioritising immigration controls and self-governance ahead of access to the single market.

The trade-off

In her speech at the Conservative Party Conference, May refused to accept that there is necessarily a trade-off between access to the single market and the free movement of labour. However, this view directly contradicts everything European leaders have said in recent months.

In any case, May was clear that the UK is “…not leaving the European Union only to give up control of immigration again…only to return to the jurisdiction of the European Court of Justice”.

May either does not understand the clear trade-off that will be presented to the UK once negotiations begin, or she is using her hard stance as a negotiating strategy. If it is the former, then the UK is heading for a very “hard” Brexit, defaulting to World Trade Organisation rules which will damage trade with Europe, and the attractiveness of the UK as an investment destination. If it is the latter, she may eventually extract a softer deal for the UK if she is willing to compromise. But, in the meantime, the signal to UK corporates and the international investment community is that the UK is heading for a hard Brexit.

Companies could relocate

For many companies who have to make a decision as to whether to continue to locate and invest in the UK, the probability-adjusted cost of remaining in the UK has just increased. Companies cannot wait at least two years to discover the eventual outcome of negotiations. They will probably opt for the safe option of leaving. The cost of moving is simply the cost of certainty, which May does not offer.

May’s hint of a hard Brexit, and the lacklustre speech from her new Chancellor Philip Hammond that followed, have sent sterling to its lowest level since 1985 – down 1.8% against the US dollar and down 1.1% against the euro (since close on 30 September 2016).

Inflation impact

Our previously-stated view that sterling has further to fall is coming to fruition, which raises the probability of our above-consensus forecast for inflation reaching 3% next year. This will be difficult for households to absorb without slowing spending as growth in real household disposable income was just 2.9% in the second quarter of this year. While the economy is still holding up, the fundamentals are weak, the imminent rise in inflation will slow activity over the next year.